No guarantees so proceed with caution

Ucits III roundtable, 6 September 2010,

Roundtable participants:

• Christophe Belhomme, CIO, FundQuest
• Tim Bell, Managing Director, Hedge Funds Advisory, UBS Wealth Management
• Marilou Calara, Head of Global Product Development, Citi
• Alex Hoctor-Duncan, Head of European Retail Sales, BlackRock
• Aidan Kearney, Co-Head of Multi Manager Funds, Aberdeen Asset Managers
• Jerome Lussan, Managing Director, Laven Partners
• James Rous, Co-Manager, Thames River Capital
• Manfred Schraepler, Head of db Funds, Deutsche Bank
• Yuri Bender, Editor in Chief, Professional Wealth Management

Yuri Bender: Ucits III structures have proved incredibly popular with fund groups. Is there a feeling this EU-approved brand may be misleading investors as to the risks involved in an underlying portfolio?

Alex Hoctor-Duncan: These products need careful handling and professional advisers have a key role to play in ensuring investors understand what they are investing in and above all invest in the product which is suitable to their specific needs. Ucits III is a fantastic innovation. It is not new, it is just that very few people initially understood the concept, because we were not used to innovation of regulation within such a structure.

In 2002, when the new investment powers came out, businesses that had the people, the energy or the foresight recognised immediately the opportunity for traditional long-only manufacturers to create and deliver something new for their customers – which is the ability to build funds which aim to deliver a consistent absolute return with lower volatility than the wider stock market. Historically, that has been the domain of the hedge fund world. Now distributors have more choice: a hedge fund or a Ucits III fund, the combination of both offering a complementary range of investment options.

But Ucits III offers no guarantee. If you do not have a skilful manager, the product will not deliver and customer satisfaction levels will be lower than expected. The decision for us about launching a Ucits III fund has to be based around a fund management team’s skill and customer suitability. You also need the strong support of risk management, infrastructure, operations and marketing – it is very relevant how a product is positioned and communicated nowadays, so clients understand what they are buying. The level of education required is much higher than people think, and professional advisers have a fundamental role to play in this area.

Yuri Bender: Is the proliferation of products really driven by investors’ demand for liquidity, transparency and regulatory oversight or is it a case that it is a difficult time to sell investment products, so the fund houses have to come up with a new way to package or, as you say, position their products?

Alex Hoctor-Duncan: Yes, there is a danger of fund houses just coming up with products for the sake of gathering assets. I heard recently about a distressed debt Ucits III fund being launched, which may or may not be true but it immediately rang alarm bells due to its possible illiquidity. We should be willing to stand up and say, ‘We do not want the Ucits III framework to be challenged like this. Customers want sensible, easily understood, recognisable products that are suitable for a diversified portfolio.’

Marilou Calara: Private banking clients have expressed interest in more liquidity and transparency for several years. But until 2008/2009 it has been a minority – you would hear it now and then, but not all the time. After the market collapsed in 2008/2009, you had clients exiting – those who were able – from alternatives funds. After a short period of time, the clamour for more liquidity and transparency was much more significant than in previous years. As was mentioned, Ucits III funds have been around since 2002. We had a handful on our advisory platform previously, but it has been during the last two years that we are seeing managers because they are getting phone calls from people like us saying, ‘What do you have in this space?’ and you start seeing a lot of the funds coming through.

We are going very cautiously into this space, so you might see today significant numbers of managers opening funds and I think there are some flows into them. But certainly for Citi, we are going very, very slowly. It has taken us at least six months just assessing what is out there and, with the number of funds coming out. There are some long-only managers wanting to play in this space, which is something we are not comfortable looking at. We want proven managers who have done this in the hedge fund space and can make these strategies work, who are now going into an environment that is slightly more controlled. We are certainly not looking at a long-only manager who has never done the short space before and thinking they can jump in. There are just too many other competitors who have better records.

Christophe Belhomme, FundQuest

Yuri Bender: Has the move towards Ucits III structures been accompanied by any significant improvement in the due diligence process?

Christophe Belhomme: Yes. In fact, for those specific products, I would say the due diligence is not the same as the one you would do for long-only products. We focus much more on operational due diligence. That means looking at risk control; we are looking at the way operations are done – trades, executions, compliance issues and also how the different actors perform their duties, especially on the custodian side because as we know, with these new products, which are quite sophisticated in terms of the investment techniques they use, it is sometimes difficult for the traditional custodian to monitor the product and to fulfil their obligations. So, it is very important that as part of the due diligence we review those facts.

Tim Bell: I was going to draw the comparison with the offshore hedge fund side, and to say the due diligence process is potentially more onerous as regards UCITS by comparison with offshore hedge funds. This is because of the extra work required to assess the Ucits structure itself and to make sure we are totally comfortable with the processes and any particular structures used. It comes, actually, very much back to Alex’s point about the concept of a distressed debt fund in a Ucits wrapper. In order to do that, by definition you would be running a substantial liquidity mis-match risk and you just have to make absolutely sure the type of hedge fund being offered as a Ucits product is totally appropriate to be offered in that way, otherwise it is quite probable there will be problems down the road.

I do not think anyone is hoodwinked into thinking that just because it’s a Ucits and regulated structure, that many of the risks necessarily go away. You have to dig right down into the weeds to make sure that the UCITS structure itself and processes used are appropriate.

Yuri Bender: The German government several years ago tried to bring in regulated hedge funds, it was possibly an experiment and did not really take off. There were derogatory comments made by German government members about alternative investments. Have the Ucits III regulations and the possibility to structure products under these broadly accepted EU directives changed the German perception to alternative investments and hedge funds in particular?

Manfred Schraepler: I do not think the sort of debate we are having today has started to develop in Germany. You see some institutional investors that show appetite for alternative investments, who might be familiar with the products we are discussing. But generally, this is not something present in the media. German retail investors are not hedge fund friendly, but we have been quite successful with alternative products that have been making use of Ucits III to the extent they have been providing exposure to, for example, commodities or currencies, which you could not really do in the old world with Ucits I.

There was a study done by PwC – you are probably familiar with the fact that certain insurance companies in Germany have a 5 per cent quota or allocation they can make to hedge funds – showing that only 2-3 per cent of the quota has actually been taken up by these institutions. They were worried about the offshore nature of the investments, lack of regulatory supervision, possibly liquidity issues. The argument made by PwC was that this Ucits development could be an interesting way for hedge funds to actually use all the entire allocations that insurance companies might be able to give so this is certainly a space to watch. There is appetite for alternative investments but I believe this discussion is a bit too early.

In Germany there was a difference of treatment between certificates, structured products and funds. Today they are on equal footing, so that debate has become less relevant. What is more relevant is the Lehman discussion in respect of counterparty risk and certainly you have seen structured product sales come down significantly since the crisis. I have not seen volumes on the mutual funds side really go up so maybe there is an equal footing between the two. It will be interesting to see what will happen in terms of alternative products and managers coming to markets in Germany.Using managers in the Ucits wrapper that comply with all German regulations could certainly be a good way of capturing investor interest in Germany.

Jerome Lussan: Managers have always tried to gain investor confidence by describing how solid their investment processes are but not necessarily revealing the actual details of the work done. Certainly in the alternatives space that has been a problem and led to lack of trust that we are trying to address today. This was the result of investors finding themselves in strategies that did not deliver as they were supposed to or were locked in or gated or finding out that the valuation of their assets was not what it was supposed to be even though they had trusted the system, the banker and the asset manager.

Because of that, we have Ucits III, which, as we have stated, was around for quite a few years but nobody was too bothered about because it is heavy to carry. It is demanding and more expensive, and at the end of the day if you work with an independent asset management company, it is not in their interest to have 50 people in back office, middle office, operations, compliance and legal functions, but rather to go with the simplest and most effective route which traditionally has been alternative offshore funds. Now that there has been a breach of confidence, asset managers are trying to get back to investors with Ucits III under which they can bring some strategies, sometimes ridiculously so, sometimes in a fair way. Ucits III is materially different in that it does and should protect the investors.

The UBP Newcastle Ucits III fund was a good example. They liquidated the fund but nobody lost anything as it had the liquidity needed and all these regulatory protections. The fear now is that we talk about due diligence on the strategy and how wonderful managers and their processes are. But due diligence is extremely difficult. It demands many hours of work, involves a lot of people who are skilled and qualified and it must be heard and listened to, which is not always the case in big institutions where there are different departments pushing for different things. I do not believe we have completely catered for that yet.

We talk about Ucits III but these structures will use swaps, swaps mean counterparties, counterparties mean less control than if it was exchange traded. We talk about commodity Ucits III vehicles - in this case commodities are prohibited by the legislation but you can somewhat achieve access to them through swaps of derivatives. Managers are far more protected presumably if they can trade a future on an exchange than if they have to use a swap to do so. I am not sure that all of our banks and asset managers are going to be able to control counterparty risks. The danger is that we are not going to be able to cater for all of the risks that we are creating for ourselves.

Aidan Kearney: In the Ucits world, 40 to 50 per cent of the empire are institutions, which you would assume carry with them due diligence and all the support packages – compliance, legal etc, that will enable the best effort to be made but within that, mistakes will still be made. If they were not, many things of the last five years would not have happened. We are talking about taking a very useful vehicle out into an entirely different marketplace. Hedge funds are trying to broaden their asset base and find new buyers for their product to spread their footprint in terms of liquidity for their businesses.

In order to do that, they bring in something new and different to the marketplace, the strategies, the skill sets, and they are doing it in a vehicle that commits this to happen. You should recognise that we have got to look at who the end buyers will be and that the door may be opened to mis-selling. Ucits vehicles are now being put onto the distribution platforms and we are selling out there. We must recognise that the buyers are different for these strategies.

Jerome Lussan: I am not sure the manager from the alternative side who is currently building a Ucits III is looking for access to a broad investor base, but rather he is trying to get back assets lost because investors nowadays are reluctant to go into an offshore structure.

Manfred Schraepler: The reality is that we have two sorts of products. We have those issued before the crisis, with an absolute return angle, that have been around for a few years and mainly coming out of the big houses, some of which are around this table, which have been successful and certainly distributed widely to retail. Then you have the new products that have come out as a result of the financial crisis, launched by hedge fund managers. They were not really available before in an onshore Ucits framework and here, what we see is that most of the assets coming into these products right now are from hedge fund investors, not from the man on the street.

Aidan Kearney: This leads into the two-speed approach. Those used to buying offshore hedge funds know what they are doing, they are just looking at the vehicle now and getting to understand how it works. Is the Ucits world going to be the death of the Cayman Island hedge fund debate? We have to recognise that Ucits is putting these vehicles out into a different buyers’ market. You may well be right in that it is about regaining assets that have been lost earlier, I am sure there is a very strong element of that. However, when you see a volatility trading product going on a distribution platform, you have to ask yourself: is that all just about getting assets back? As well as renewing the future life of the hedge fund world, Ucits brings new buyers to the marketplace

Marilou Calara: You should not expect the same returns because these managers have limited powers – yes it is expanded from long-only, but these are not the same as the hedge fund. For us, it is a balancing act in terms of communication with our bankers who are selling these. We recognise it as a new space, with great opportunities, but at the same time we are still very much wary of what can go wrong. The history is not very long of all these other new funds.

Yuri Bender: Thames River has been in the news regarding the merger with F&C. We see F&C having the institutional business, while you hold the relationships with the big wealth managers. Now that you have the Ucits III long-short fund, what kind of reaction are you getting from the wealth managers to the new format, when they have previously been used to the Cayman funds?

James Rous: We explicitly state that our Ucits III fund of funds is a lower volatility, lower risk and return objective product than our flagship Cayman fund of funds products. To our existing client base we are positioning this very much as a more conservative product, compliant with both the letter and spirit of the regulations. It is worthy of note that although Ucits III was explicitly designed for the protection of retail investors, as time has gone by an unexpected consequence has been interest from institutional players such as European insurance companies and pension plans. We are saying that it is appropriate for an investor who wants a more liquid product, a more transparent product and a more regulated product, albeit with a somewhat constrained range of strategies. We have not embraced risks such as highly levered or illiquid strategies in Ucits III.

Yuri Bender: A recent report from the Strategic Insight Consultancy highlighted ‘strong concern in the distribution and wealth management community that hedge funds are driven by business pressures and uncertainties about the forthcoming AIFM directive, which may pose restrictions on marketing of offshore hedge funds,’ so they are offering strategies not really suited to the Ucits format. Perhaps they might not provide liquidity during times of stress. Is this a big concern for wealth managers?

Jerome Lussan: The draft AIFM directive was a cue for a lot of asset managers who are traditionally offshore to consider what options they had onshore. I think that ties in with the idea of responsibility and trust that we were talking about earlier because from an investor’s point of view, if you got stung offshore then you are looking for something else and everyone is saying Ucits III is that something else. In conjunction with the AIFM proposing that you may not be able to promote foreign funds in the future in Europe, I think these two parallels coming together have driven the demand.

Yuri Bender: Where is future interest in Ucits III likely to come from, according to your conversations with clients?

Christophe Belhomme: Mainly from private banking and also from institutional investors. On the retail side, the distributors remain rather sceptical because Newcits techniques are quite difficult to explain, making it more difficult for a banking network to sell such products. There is also a risk of misunderstanding by the end client, particularly when it comes to liquidity profile and investment horizon.

Retail clients are accustomed to daily liquidity, which some Newcits are unable to provide. We therefore believe the most appropriate way for retail clients to gain exposure to diversification benefits of Newcits is through multi-asset portfolios. In managing such portfolios we ensure the alignment between the liquidity of the product and the liquidity of the underlying investments.